What is the Physical Settlement of Futures & Options Contracts?

Futures and options (F&O) contracts are derivatives that derive their value from underlying assets such as stocks, commodities, or indices. Traditionally, many F&O contracts were settled in cash, meaning traders received or paid the difference in price instead of taking possession of the asset. However, in recent years, regulatory bodies like SEBI (Securities and Exchange Board of India) have mandated physical settlement of stock derivatives to curb excessive speculation and improve market stability.

In this article, we will explore physical settlement of F&O contracts, its working mechanism, margin requirements, advantages, and disadvantages, along with key differences from cash settlement.

What is Physical Settlement in F&O? 

Physical settlement means that when a futures or options contract expires, the holder must either deliver (in case of a sell position) or take delivery (in case of a buy position) of the underlying asset. Unlike cash settlement, where only the profit or loss is adjusted in cash, physical settlement involves actual transfer of shares or commodities.

For example, if an investor holds a buy position in a stock futures contract and does not square off before expiry, they will have to take physical delivery of the stock in their demat account.

Importance of Physical Settlement in Derivatives Trading 

SEBI introduced mandatory physical settlement to prevent excessive speculation and ensure derivatives trading aligns more closely with actual market activity. The key reasons include:

1. Preventing Excessive Leverage: Many traders use F&O for speculation with high leverage. Physical settlement ensures only serious traders participate, as they need sufficient funds or stocks.
2. Curbing Market Manipulation: Cash settlement allowed manipulation by influencing stock prices near expiry. Physical settlement reduces such practices.
3. Aligning with International Standards: Many global markets have physical settlement mechanisms, ensuring better integration with global financial systems.
4. Enhancing Stability in the Market: Ensures delivery-based trading, reducing volatility caused by speculative positions.

Basics of Futures and Options Contracts 

Before understanding physical settlement, it's crucial to grasp the fundamentals of futures and options contracts:

• Futures Contract: A legally binding agreement to buy or sell an asset at a predetermined price on a specified future date.
• Options Contract: Provides the holder the right (but not the obligation) to buy/sell an asset at a pre-agreed price before expiry.

F&O contracts are commonly used for hedging and speculation. However, due to the risk of excessive speculation, physical settlement ensures traders take actual ownership of assets, rather than engaging in leveraged betting.

How Does Physical Settlement Work in F&O? 

The process of physical settlement depends on whether the trader holds a futures contract or an options contract at expiry. The settlement takes place based on the final settlement price (FSP), which is the closing price of the underlying asset on the contract's expiry date.

Steps in Physical Settlement:

• Identification of Contracts: The exchange (NSE/BSE) identifies contracts requiring physical settlement.
• Broker Notification: Brokers inform traders of margin adjustments or stock deliveries needed.
• Fund/Stock Requirement: Traders must ensure adequate funds or stock availability.
• Exchange Facilitates Transfer: The exchange facilitates the transfer of stocks between counterparties after expiry.

Physical Settlement in Futures Contracts 

In futures contracts, both buyers and sellers must exchange the underlying asset at expiry.

Example:

• Suppose you buy 100 shares of a company’s Futures at ₹ 2,500 per share.
• If you hold the position till expiry and the final settlement price is ₹ 2,550, you must take delivery of 100 shares at ₹ 2,550 per share.
• If you had a sell position, you would need to deliver 100 shares instead.

Key Points:

• Buyers must arrange funds to take delivery.
• Sellers must ensure they have enough stocks to deliver.
• If stocks are unavailable, penalties are imposed.

Physical Settlement in Options Contracts 

The settlement process for options differs based on the type of contract:

Call Options (Buyers & Sellers)

• If you hold a long call option (buy position), you must take delivery of the underlying stock if the contract expires in-the-money (ITM).
• If you write a call option (sell position) and the contract expires ITM, you must deliver the stock.

Put Options (Buyers & Sellers)

• If you buy a put option, you must deliver the stock at expiry if ITM.
• If you sell a put option, you must buy the stock at expiry if ITM.

Example:

• You buy a call option on a company with a strike price of ₹ 3,200.
• If it closes at ₹ 3,250 on expiry, the contract is ITM, and you must take delivery at ₹ 3,200 per share.
• If you held a sell position, you must deliver the stock.

Regulatory Framework for Physical Settlement 

SEBI and stock exchanges regulate physical settlement under strict guidelines:

• Mandatory Physical Settlement: Introduced in 2018, making it compulsory for stock derivatives.
• Margin Requirements: Traders must maintain increasing margin amounts as expiry nears.
• Settlement Obligation Enforcement: Exchanges enforce penalties for non-compliance, including auctions for short deliveries.

These regulations aim to create a fair, transparent, and less speculative derivatives market.

Since physical settlement involves actual delivery, traders must maintain sufficient margin in their accounts.

1. For Buyers:
   • They must ensure they have enough funds to buy the required stocks.
2. For Sellers:
   • They must hold the required quantity of stocks in their demat account.
3. Brokerage Adjustments:
   • Brokers may ask for additional margin closer to expiry to ensure smooth settlement.

Failure to meet these requirements can lead to penalties and forced closure of positions by brokers. Specific scenarios include:

• Short delivery of stocks: Leads to an auction with penalty charges.
• Insufficient funds for buying stocks: Margin shortfall penalty may be imposed.
• Failure to meet margin requirements: Risk-based square-off can occur.

Timeline and Procedure of Physical Settlement 

The settlement process varies for futures and options but follows a defined timeline:

For Futures and ITM Short (Call & Put) Options Positions, on the expiry day, the margin requirement increases to 40% of the contract value or SPAN + Exposure, whichever is higher.

For ITM Long (Call & Put) Options Positions, the margin requirement increases 4 days before expiry (which is, typically, the last Thursday of each month), as follows:

Financial Implications of Physical Settlement 

Physical settlement impacts traders and investors in various financial ways:

1. Capital Requirement:

• Traders need substantial funds or stock holdings, unlike cash settlement which only adjusts price differences.
• Investors may have to liquidate other holdings to meet settlement obligations.

2. Higher Transaction Costs:

• Physical delivery leads to brokerage, DP charges, and stamp duty, increasing the cost of trading.
• Traders need to factor in these additional costs before entering F&O trades.

3. Risk of Stock Price Fluctuation:

• Traders exposed to actual stock ownership face market risk beyond contract expiry.
• Unexpected price movements may lead to substantial gains or losses after settlement.

4. Portfolio Planning:

• Investors must plan ahead to ensure margin requirements are met to avoid penalties or forced liquidations.
• Strategic portfolio allocation becomes crucial to manage settlement obligations.

Risks and Challenges in Physical Settlement 

Despite its advantages, physical settlement comes with risks and challenges that you should be aware of:

1. High Margin Requirements:

• Increased margin obligations can lead to liquidity constraints for traders.
• Sudden changes in market conditions may require additional funding on short notice.

2. Auction Risk for Short Delivery:

• Failing to deliver stocks triggers an auction with penalties.
• The auction price may be significantly higher than the expected settlement price, increasing losses.

3. Limited Flexibility:

• Unlike cash settlement, physical settlement requires asset handling, reducing trading flexibility.
• Traders must carefully plan positions to avoid unnecessary delivery obligations.

4. Market Volatility Impact:

• Unexpected market moves can lead to sudden margin calls, forcing traders to sell holdings at a loss.
• Increased market volatility near expiry can lead to forced settlements.

5. Operational and Administrative Complexities:

• Physical delivery involves coordination between brokers, exchanges, and clearing corporations.
• Traders must comply with strict deadlines to avoid settlement failures.

Best Practices 

• Always track your open F&O positions before expiry to avoid unwanted physical settlement.
• Maintain sufficient funds or stocks to meet settlement obligations.
• Consult your broker for margin requirements closer to expiry.
• Understand your contract type (futures or options) to plan your strategy effectively.

Conclusion 

Physical settlement in F&O contracts has transformed the derivatives market by reducing speculative trading and ensuring actual stock ownership. While it increases capital requirements and obligations, it also brings stability and transparency. As a trader, understanding the mechanics of physical settlement helps in making informed investment decisions and avoiding unexpected risks at contract expiry